Saturday, December 25, 2010

Why America's Trade Deficit Is Smaller Than It Looks

For the latest 30 years, America have had a constant current account deficit, and often a quite large one. This means that America have had constant net borrowing from abroad. One would have expected then that it would have to give up now some of its production (or at least borrow more) to cover the interest (or profits in case the deficit was paid for by selling stocks). Except that it hasn't.

During the first 3 quarters of 2009, America had a net factor income surplus of $191.6 billion, at an annual rate. That is a dramatic increase from 1980, when the surplus was just $34.2 billion. Even if you adjust for inflation, it represents a dramatic increase as the 1980 surplus was $79.1 billion in 2010 dollars. Indeed, it is an increase even relative to GDP, as the 1980 surplus was 1.23% of GDP, while the 2010 surplus was 1.31%.

But how is it possible for America to pile up more and more debt and yet still receive more and more net capital income?

There are two explanations:

One is that some of this capital income really isn't capital income-it is the result of tax planning by U.S. companies. Many U.S. companies decides to attribute profits to Ireland and other low tax countries. The result is that Irish trade statistics falsely shows that Ireland has a really large trade surplus-but also a really large factor income deficit. The flip side of this is that the U.S. trade deficit is overestimated while the factor income surplus is also overestimated.

But why do non-American investors keep investing in U.S. government bonds when they both have lower expected return and a higher risk (due to the exchange rate factor)? As I pointed out here, this is likely in some cases the result of some private investors being unaware of this or thinking (in some cases correctly, in others incorrectly) that the U.S. dollar is temporarily significantly undervalued. In other cases, it is the result of foreign governments in the form of sovereign wealth funds or central banks actively trying to hold down the value of their currency for usually mercantilist motives.

Foreign investments in one of the worst possible investments in the world, U.S. Treasuries, represents intentionally in the case of sovereign wealth funds and central banks, or unintentionally in the case of private investors a rebate on their exports and extra payments on their imports from America. Or in other words, Americans really don't pay as much for their imports as the trade statistics suggests and they similarly get paid more for their exports than the trade statistics suggests.

The implication of this is also that the trade deficit is actually exaggerated-while the factor income surplus is also exaggerated and is in fact probably an illusion alltogether.

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